«Abstract This chapter on macro aspects of taxation begins with a discussion of the contribution of taxation to stabilization policies. The budget ...»

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In the early stages of demand management policies, the ‘loose’ reasoning was that, by a judicious timing, no public finance instrument would, over the business cycle, create financing problems. This would be the result of the automatic stabilizing properties of taxation. This view was supported by the spectacular decline in the debt ratio after the Second World War. Later, however, the criticism by monetarists was supplemented by the argument that the budget constraint was neglected. By explicitly incorporating the financing aspects of government decisions two important modifications had to be made to the traditional analysis: fiscal and monetary policy became interrelated and the long-run multipliers were no longer uncertain. References to the basic articles and developments are: Ott and Ott (1965), Christ (1967, 1979), Silber (1970), Steindl (1971), Blinder and Solow (1973, 1976), Meyer (1975), Brunner and Meltzer (1976), Currie (1976), Tobin and Buiter (1976), Cavaco-Silva (1977), Smyth (1978), Cohen and De Leeuw (1980) and Mayer (1984) (surveys are to be found in Turnovsky, 1977; Artis, 1979; and Burrows, 1979). In these contributions, it is stressed that any tax reduction has to be financed implying that the budget constraint must be included in the analysis.

This endogenized at least the supply of bonds, possibly money creation and therefore monetary policy. The longer-run consequences on the multipliers strengthened the macroeconomic importance of the marginal tax rate: any change in expenditures (or taxes) must be offset by an identical change in taxes (or expenditures) since no deficit and therefore no monetary or bond financing is allowed. The consequence is the irrelevancy of the method of financing the deficit; only the fiscal structure determines the long-run impact of fiscal policy.

Note, however, that this attractive result disappears when interest payments are explicitly included into the budget constraint (Blinder and Solow, 1973, 1974).

The size of the long-run multiplier associated with a bond-financed fiscal expansion increases, since taxes must now also finance the higher interest charges. The Blinder-Solow model was extended to include explicit stock-flows interaction of capital and bonds by Tobin and Buiter (1976). Calvo (1985) allows for price increases in a model were the money-bond ratio is important.

16 Taxation: Macro Aspects 6010

4. Rational Expectations

The budgetary constraint criticism of the traditional stabilization instruments is based on the accounting argument that expenditures and revenues are linked by the budget constraint. In the 1970s, further blows on the stabilization approach were inflicted on the basis of more behavioral arguments. Indeed, the traditional approach assumes, although implicitly, that all policy changes occur unexpectedly. The rational expectation assumption, based on Muth (1961), argues that economic agents form expectations about future events. These expectations are rational in the sense that they combine all the available information and therefore do not lead to systematic forecasting errors. The implication of the rational expectations hypothesis is that policies will only be effective when they produce surprises (= forecast errors). By definition, this is not possible in the long run since rational economic agents will detect any policy rule and will therefore no longer be surprised. This is also known as the ‘irrelevance hypothesis’. This view has been applied to several policy instruments, most of the time of monetary policy; the core arguments are, however, also relevant to fiscal policy and taxation. The main contributions can be found in Fischer (1980b) and Lucas and Sargent (1981); Baily (1978) and McCallum and Whitaker (1979) apply the monetary policy results to fiscal policy. For our problem at hand it implies that any general expected tax change will already have been discounted by the economic agents in their decision process. An unexpected transitory change in taxation will leave permanent income unchanged. Only permanent unexpected changes are of interest. When government expenditures remain constant, the Ricardo equivalence theorem applies (see below) so the new tax policy will be ineffective. If government expenditures are reduced, the traditional expansive effects, depending on the tax rate change, will apply. The final effects on macroeconomic variables depend on the specification of the model. For example, what is the impact of an increased demand on inflationary expectations? One important policy implication is that fiscal consolidations should not necessarily contract demand due to the benign effects on the expectations about future taxation (see Giavazzi and Pagano, 1990, for an application to Denmark and Ireland). Note that the introduction of uncertain shocks modifies the previous picture slightly in the sense that built-in stabilizers will reduce the variability of income since they provide an automatic and immediate adjustment to current disturbances (McCallum and Whitaker, 1979).

Notwithstanding the previous conclusion on the ineffectiveness of stabilization policies in a rational expectations framework, microeconomic considerations such as the incentives effects of marginal tax rates, social security payments, subsidies, and so on, on labor supply, saving behavior, investment, and so on, imply that even perfectly anticipated policy changes will have some real effects in the medium run. Furthermore, the previous analysis assumes a systematic clearing of the markets. If this assumption is relaxed and a disequilibrium framework is accepted, the standard Keynesian effects reappear even when expectations are rational (see Taylor, 1979; Begg, 1982;

Neary and Stiglitz, 1983, and Buiter, 1980b).

5. The Timing of Taxation

In the traditional stabilization approach, higher deficits are a crucial instrument to increase growth. However, if expenditures remain unchanged this implies, that sometime in the future taxes will have to be raised. Deficits are thus an instrument to transfer taxes intertemporally. Will citizens be aware of this and take future taxes into account in their decision process? In other words, is there a burden associated with government debt? The discussion on the burden of the government debt emerged forcefully around 1960 (most contributions are in Ferguson, 1964, and Kaounides and Wood, vol. 2, 1992; see also Buchanan, 1958; Modigliani, 1961; Bailey, 1962; Pesek and Saving, 1967, and Cavaco-Silva, 1977).

The mainstream Keynesian position (also known as ‘the new orthodoxy’) was that government debt was different from private debt (repayment of principal and payment of interest is mortgaging future resources) since ‘we owe government debt to ourselves’: future generations pay interest and principal to themselves so leaving disposable income unaffected. This argument was reinforced by the proposition that the deficit cannot be a burden on future generations because their resources are unaffected; the exception being foreign debt. These views were criticized since higher deficits implied lower taxation.

This allows current generations to consume more and so to crowd out investment. Future generations thus inherit less capital. The distinction between domestic and foreign debt is not relevant since, although foreign debt does not crowd out investment, the revenue from the capital will benefit foreign lenders. Posner (1987) extends this view by arguing that foreign borrowing allows higher investment. Ceteris paribus, the burden of the internally held debt will be higher than for foreign debt.

In 1974, Barro rephrased the problem of the debt burden in ‘Are Government Bonds Net Wealth?’. By doing so, he could focus the attention on 18 Taxation: Macro Aspects 6010 the behavior of taxpayers. Barro showed that the real burden on current and future generations occurs when government uses resources for consumption; the financing of government expenditures (taxes or borrowing) is not relevant: they are equivalent (tax neutrality). This proposition is now known as the ‘Ricardian equivalence theorem’ (some of the papers by Ricardo are reprinted in Kaounides and Wood, vol. 1, 1992; for a discussion on the historical origins see Buchanan, 1976; O’Driscoll, 1977, and Asso and Barucci, 1988; see also Hakes and McCormick, 1996).

The novel feature of Barro’s approach is that he showed that intergenerational gifts and bequests turn an overlapping-generations economy with finite-lived households into an infinite-lived households economy whose consumption would not be affected by intertemporal redistributions of lump-sum taxes.

Phrased in a stabilization framework, the Ricardian equivalence theorem holds that when the government issues bonds, at the same time a liability is incurred to pay interest annually and to reimburse the par value at the date of maturity. Formulated from a wealth point of view, the net present value of the future tax liabilities equals the price of the bond. If taxpayers do capitalize future tax liabilities, the positive gross wealth effects of a bond issue will be offset by an equivalent liability leaving net wealth unchanged. Government bonds will then not be part of net private wealth. In other words, a decrease in public saving will be exactly offset by an increase in private saving, leaving total saving unchanged. Formulated from a financing point of view, the financing of government deficits is irrelevant for the real side of the economy so a substitution of debt for taxation does not affect economic development. As a result, in this ultrarational situation fiscal policy is ineffective. This can be viewed as ‘ex ante crowding out’ (David and Scadding, 1974). If the macroeconomic effects of current taxation are comparable to those of deficits, a choice between current or future taxation will have to be made by considering allocative effects (see Ihori, 1988).

Tramontana (1985) and Fields and Hart (1990) place the discussion in a traditional IS-LM framework.

The Barro proposition resulted in an intense discussion and many empirical tests. Several authors, especially Keynesians, questioned his assumptions. Since taxes are in general not lump-sum taxes, tax changes involve modifications in the size and timing of marginal taxation. This affects incentives and induces intertemporal substitution effects (Buiter, 1989, and Trostel, 1993). One can also question whether taxpayers are interested or informed about taxes and the 6010 Taxation: Macro Aspects 19 government debt. This refers to the existence of fiscal illusion (Stiglitz, 1988).

Similarly, is the public not assuming that government has no intention of paying off the principal (Cox, 1985)?

Barro (1974) showed that the infinite life assumption is sufficient but not necessary for his proposition. A finite life assumption has the same implication if one assumes that the current generation considers the wellbeing of future generations and adjust intergenerational transfers (bequests or transfers inter vivos) to interventions of the government (for example, a tax reduction will be matched by an increase in voluntary tranfers). Expenditures on education are different since a government deficit can increase welfare: parents will be allowed to invest more in their children’s education (see Drazen, 1978). Further discussion about this issue is to be found in Blanchard (1985), Hubbard and Judd (1986), Auerbach and Kotlikoff (1987), Frenkel and Razin (1987), Poterba and Summers (1987), Weil (1987), Abel (1988), Bernheim and Bagwell (1988), Musgrave (1988), Kotlikoff, Razin and Rosenthal (1990), Lopez and Angel (1990), Abel and Bernheim (1991), Lord and Rangazas (1993) and Jaeger (1993).

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